Tax Talking: Touching on the Basics

There are few things in finance, that I believe are ABSOLUTELY necessary for everyone to know. Taxes are one of those things. They serve an integral part of our society and have everyday roles and ramifications. On the government side, they are revenue for infrastructure and well as behavior modification to reduce things like smoking and drinking. On the citizen and business side, they’re the bane of our existence. I know everyone has their opinion on taxes, but they do serve an important role in our society. More importantly, they’re probably not going away anytime soon either.

Because taxes are as inevitable as death, I’d like to break down some of the tax basics. Just some terminology and basic application of core concepts. It’s easy to surf the web, especially around April, and see incredibly misleading headlines. I remember the old one that simply said “Warren Buffett pays less in taxes than his secretary.” I was so annoyed! The headline implied that Buffett paid less in total taxes. There is simply no way. Yet many people believed it and began to repeat it: “Buffett pays less taxes than his secretary.” It was a simple misunderstanding of vocabulary.

Income Tax

We’re all familiar with the income tax. It’s the reason people complain, and why accountants drink. There are a number of laws about what income is taxed and how, but they’re really not all that important to know. What is important is knowing that there are marginal rates and there are effective rates.

When you talk tax rates, you’re probably talking about marginal rates. That is, the rate at which your next dollar earned is taxed. There are seven brackets ranging from 10% to 39.6% and you can be in multiple brackets at the same time. While the IRS differentiates between single filers and married couples filing together, for the purpose of this article I will only be using single filers as an example. Now then, for an example on brackets. Let’s say there is a pretty rad engineer and they make around $250,000 a year. That places them in the 33% marginal tax bracket, and everything below it. So for every additional dollar they make (up to $413,350 for 2016) it will be taxed at 33%.

For the brackets below the 33%, our engineer will be taxed accordingly. The first $9,275 is taxed at 10%, the next $9,726 to $37,650 is taxed at 15% and so on and so on. You can see the 2016 tax brackets here if you would like a visual aid. Because the income is taxed in tiers, it means your actual tax rate, otherwise known as the effective tax rate is lower than your marginal rate. In the last example, if we assume zero deductions (not even the standard deduction or personal exemption), our rad engineer pays around $66,000 in yearly taxes for an effective rate of 26%. So again, even though his marginal rate is 33%, he actually only paid 26% of his income in taxes. FICA, Medicare, and Social Security are completely different animals and are also not included in this example.

Investment Tax

Income, depending on how it was earned, is taxed differently. Two wealthy people, who earn the same amount of money, could have drastically different effective rates. This generally occurs because one of them makes their income through a wage, while the other makes it through dividends from stock and other long-term capital gains.

Qualified dividends and long-term capital gains (stocks or assets held for longer than a year) are taxed at 15% for most people. If you happen to fall in the 10% or 15% brackets, you pay no taxes on long-term gains and if you fall in the 39.6% bracket, you pay 20%. Regardless, even if you’re in the top bracket paying 20% on capital gains, that’s still nearly 20% lower than what you would be paying on wage income. Thus, a doctor making $400,000 a year from their firm and a wealthy individual living on $400,000 in dividend and stock earnings would have very, very different taxes overall.

Now you may wonder why we cap investment income so low and give preferential treatment. There are two main reasons for this. The first is that the government wants to incentivize investment earnings. It’s a great tool for producing wealth (just take a look at my article on how I made great earnings on the Brexit). More wealth means more taxable income and consumption in the economy. The second reason, and probably the more pertinent, is that the income has already been taxed when it comes from dividends!

Corporations pay out money to shareholders in order to drive stock price growth. That growth can provide incentives for employees in the form of stock options, and it can be used as leverage when it comes time for financing deals. The shareholders get this money in quarterly or yearly dividends from the company. The money itself comes from earnings that have already been taxed by the government, so when you receive a dividend – and then pay taxes on it – it’s a form of double taxation. This double taxation makes dividends a highly inefficient form of income and thus, the government seeks to minimize this inefficiency by creating lower taxes rates for it.

The Takeaway

Now you hopefully see why that misleading headline about Buffett annoyed me. Buffett paid more taxes when you consider the ACTUAL tax amount paid – in 2010 he was reported to have paid a cool 6.9 MILLION in taxes. It goes without saying that had Buffett earned a wage income, he would be taxed in the 39.6% bracket. However, his effective rate was lower than his secretary because he didn’t earn a wage. He earned capital gains and thus benefitted from the preferential treatment. It’s just the nature of the beast. Fortunately, there are volumes of information available for free over the internet and at your local library for learning how to trade stocks and manage your own portfolio. You may never be the Oracle of Omaha, but you can reduce the exorbitant fees charged on your retirement and invest into low cost index funds.

Let’s also not forget that understanding these basic concepts translates into your ability to understand the political dialogue in our country. By not confusing concepts, and getting distracted by misleading and disingenuous headlines, we can better shape the national conversation on tax reform. This should be our ultimate goal, a progressive tax system that runs efficiently.

Readers, have you made the common mistake of confusing tax terms? How do you try and reduce your taxable income each year? Discuss in the comments below. Also, don’t forget to ‘like’ Cash Flow Celt on Facebook to get the latest updates. If you would rather find out how you can save money each month by getting a great cell phone plan, be sure to read my review on Republic Wireless!

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I'm just a local business and finance nerd looking to help people get educated about small business, marketing, and personal finance! I write about anything and everything that I can tie into those themes. I'm also Central Florida's only Kilted Realtor, so I write about Real Estate too! Check out my About Me page to see the origins of Cash Flow Celt.